Thursday, March 5, 2009

Forbes: Repeal Mark-to-Market for Assets

Steve Forbes has been calling for Mark-to-Market to be repealed since before the financial crisis last fall. He repeats himself very convinicingly in the Wall Street Journal today.

Back when the $700 billion TARP program was being debated during the heat of the presidential campaign, Newt Gingrich was calling for Mark-to-Market to be based on a 3-year rolling average.

In the wake of the accounting scandals of Enron, WorldCom, etc. earlier in the decade, the Bush administration, along with Congress, tried to tighten up accounting standards. As part of this whole push, the SEC re-instituted Mark-to-Market accounting. The rule says that if you are holding something that drops in value, you have to reflect that loss of value in your net worth. For banks, this loss of value increases their capital requirements, the amount of cash on hand they must keep to meet their obligations.

So when the housing market started falling, any banks with Mortgage-backed securities had to start marking down their asset values. Because of the lack of transparency as to which MBS's were solid and which were in trouble, no one was willing to buy any of them and the MBS market collapsed. Regulators forced banks to mark their MBS's down by as much as 80%, even when the underlying mortgages had only dropped less than 10%. Banks were hit with the double-whammy of being unsure who it was safe to lend to as well as having their capital requirements dramatically raised. As a result, the credit market froze, and the wider economy soon began to be affected by the lack of credit. Businesses startups could not find funding, and existing businesses had trouble finding short term payroll loans, or loans for projects to expand their business.

Mark-to-Market does not make sense for troubled Assets whose underlying value has not dropped nearly as much as the short-term distressed value. It is pro-cyclical. That is, it increases banks' ability to lend when the market is going up, further inflating asset bubbles, and hurts banks' ability or willingness to lend when the market is going down, greatly exacerbating financial distress.

Mark-to-Market was finally discontinued in 1938 near the end of the Great Despression, after helping cause the financial crisis at the start of the Depression. It was just reinstituted in 2007, just in time to help kick-start this recession.

Steve Forbes also casts blame for removing the uptick rule on short selling, a practice where someone borrows a stock and then sells it, assuming the price will drop so they can buy the stock at a lower price to repay the original lender, pocketing the difference between what they sold it for and what they paid to buy the stock back. The uptick rule said that you could only do this after the stock price had risen, stopping investors from being able to artificially drive down the price of a stock by repeated short-selling. You can see that without the uptick rule, there is a perverse incentive for short-sellers to pick a stock and drive it down as much as possible.

Forbes also blames the SEC for not properly enforcing the rule against naked short selling, where a trader doesn't even bother to borrow a stock before short selling it. I have no idea how much this happened, but to the extent it did, it would drive stocks down.

From a political perspective, on these specific accounting and enforcement rules, you can fairly blame the Bush administration, but an equal amount of blame must go to Democrats and the Obama administration. I am not aware of a single Democrat that has called for a change to these rules. Only free-market conservatives have been talking about this. Democrats are too busy blaming "greed on Wall Street" to realize that bad goverment regulations and rules are 10 times worse.

This is much more complicated than who is for regulation and who is against regulation. Conservatives believe that a proper role of government is to ensure orderly markets and aggressively prosecute those who break the law and try to profit by illegal means. To the extent that smart & effective regulations are necessary to accomplish this, conservatives fully support regulation. But when regulations are unnecessary, don't make sense, reduce economic stability, or are economicly harmful, conservatives oppose them.

These are important rules at the heart of the financial crisis, and they are barely being talked about. If this isn't evidence of the need for a better medium to include all Americans in a more serious and constructive dialogue about the best way forward, I don't know what is. Instead, we get lost in all this nonsense of which politician said what, how long will Obama's popularity last, is the Republican party down for the count, etc. The coverage of the presidential election was 3/4 about the horse race (who was campaigning where, what the latest polls were) and only 1/4 about which policies were best.